Financing Mix and a Firms Life Cycle

Earlier in this chapter, we looked at how a firm's financing choices might change as it makes the transition from a start-up firm to a mature firm to final decline. We could look at how a firm's financing mix changes over the same life cycle. Typically, start-up firms and firms in rapid expansion use debt sparingly; in some cases, they use no debt at all. As the growth eases, and as cash flows from existing investments become larger and more predictable, we see firms beginning to use debt. Debt ratios typically peak when firms are in mature growth.

How does this empirical observation relate to our earlier discussion of the benefits and costs of debt? We would argue that the behavior of firms at each stage in the life cycle is entirely consistent with making this trade off. In the start-up and high growth phases, the tax benefits to firms from using debt tend to be small or non-existent, since earnings from existing investments are low or negative. The owners of these firms are usually actively involved in the management of these firms, reducing the need for debt as a disciplinary mechanism.

On the other side of the ledger, the low and volatile earnings increase the expected bankruptcy costs. The absence of significant existing investments or assets and the magnitude of new investments makes lenders much more cautious about lending to the firm, increasing the agency costs; these costs show up as more stringent covenants or in higher interest rates on borrowing. As growth eases, the trade off shifts in favor of debt. The tax benefits increase and expected bankruptcy costs decrease as earnings from existing investments become larger and more predictable. The firm develops both an asset base and a track record on earnings, which allows lenders to feel more protected when lending to the firm. As firms get larger, the separation between owners (stockholders) and managers tends to grow, and the benefits of using debt as a disciplinary mechanism increase. We have summarized the trade off at each stage in the life cycle in figure 7.10.

As with our earlier discussion of financing choices, there will be variations between firms in different businesses at each stage in the life cycle. For instance, a mature steel company may use far more debt than a mature pharmaceutical company, because lenders feel more comfortable lending on a steel company's assets (that are tangible and easy to liquidate) than on a pharmaceutical company's assets (which might be patents and other assets that are difficult to liquidate). Similarly, we would expect a company like IBM to have a higher debt ratio than a firm like Microsoft, at the same stage in the life cycle, because Microsoft has large insider holdings, making the benefit of discipline that comes from debt a much smaller one.

Figure 7.10: The Debt-Equity Trade off and Life Cycle

$ Revenues/ Earnings

Tax Benefits

Stage 1 Start-up




Zero, if losing money

Stage 2

Rapid Expansion

Low, as earnings are limited

Stage 3 High Growth

Increase, with earnings

Stage 4

Mature Growth

Stage 5 Decline





High, but declining

Added Disceipline of Debt

Low, as owners run the firm

Low. Even if public, firm is closely held.

Increasing, as managers own less of firm

High. Managers are separated from

Declining, as firm does not take many new investments

Bamkruptcy Cost

Very high. Firm has no or negative earnings.

Very high. Earnings are low and volatile

High. Earnings are increasing but still volatile

Declining, as earnings from existing assets

Low, but increases as existing projects end.

Agency Costs

Very high, as firm has almost no assets

High. New nvestments are difficult to monitor

High. Lots of new investments and unstable risk.

Declining, as assets in place become a larger portion of firm.

Low. Firm takes few new investments

Need for Flexibility

Very high, as firm looks for ways to establish itself

High. Expansion îeeds are large and mpredicatble

High. Expansion needs remain unpredictable

Low. Firm has low and more predictable investment needs.

Non-existent. Firm has no new investment needs.

Net Trade Off osts exceed benefits Minimal debt osts still likely o exceed benefits. Mostly equity

Debt starts yielding net benefits to the

Debt becomes a more attractive option.

Debt will provide benefits.


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